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An article on debt posted on ZeroHedge came to our attention: Consumer Debt – Still A Long Way To Go. It has a chart that we have seen much of recently, which we now reproduce from FRED® for the household sector as the blue line of total credit market debt and the red line as the total of outstanding mortgage debt.

Although all other forms of consumer debt are rising, mortgage debt and total debt are falling. As the article notes (emphasis ours):

This would be good news as lower debt levels means more personal savings which would lead to productive investment. It would also mean more consumption that would provide stronger end demand to businesses. Both of these outcomes are necessary for sustained economic growth. The chart below has been used repeatedly to argue the deleveraging case for the economy.

This is standard economic doctrine. Apart from the fact that increased savings would not spur economic investment because the economy is swamped with – not starved for – liquidity, the falling mortgage debt levels do not translate into increased spending and the rising levels of other forms of consumer credit imply the opposite. The reason is the asymmetric relationship between total debt and debt servicing costs.

We have tracked Canadian Home prices for some time: Tracking Canadian House Prices. In our latest update we suggested that prices had peaked as seen by the recent August decline of 0.35% in the eleven markets surveyed. What we haven’t reported on are the double digit declines of salesin the hottest markets. When sales decline, houses take longer to sell and buyers who can’t wait are forced to reduce their price. The risk is that everyone will head to the exits at once in a highly speculative market. And certain cities that the National Bank home price survey reviews have to be classified as speculative.

Yesterday when we posted Flash Point: Cracks in the Canadian Economy, we referenced a CBC article that stated the current household debt to disposable income ratio was at a record high. We did not report on the part of the article that referenced the housing market. One quote we went back for is:

Ottawa has moved four times in as many years to tighten mortgage rules to keep marginal buyers out of the market, most recently in August.

That the Canadian Finance Minister is sufficiently “concerned” (widely reported in the media for example Jim Flaherty concerned about Canadians mortgage debts) about household mortgage debt to repeatedly introduce measures to dampen it is monumental. An expression of “concern” from authorities is as close to an admission of the existence of a bubble as we will get. No minister is going to come out and say that the housing market is in a bubble and will contract by some number, say 30%.

We have long been aware of the close parallel between the US and Canadian economies on two dimensions, growth in house prices and growth in household debt. In the US, the combination resulted in a crash in prices that may still not have bottomed. The Canadian numbers are even worse than the US numbers making a housing crash a possibility here.

A more in-depth analysis of the situation is given in this post by Pater Tenebrarum of Acting-Man blog titled Is Canada’s Housing Bubble ‘Different’? In it he would seem to conclude that Toronto and Vancouver a re in housing bubbles. He has an interesting take on Canadian commercial banks to mortgage debt default exposure.

We would sum the situation up as having Toronto and Vancouver in definite local bubbles which are due for correction. Unfortunately, the effects will be felt in all markets.

We noticed recently that the Canadian economy shrank in August by 0.1%. As reported by CTV news (Shrinking GDP suggests Canada hit by global slowdown): The slowdown affected 10 out of 18 sectors of the economy, including manufacturing, construction, mining, and oil and gas extraction. The report was disturbing because the sectors contracting are the high value sectors of the economy and responsible for both jobs and export wealth.

This report came two days after Reuters reported: Canada says GDP growth holding, but tax revenues off. Reuters quoted Finance Minister Jim Flaherty as saying Canada expects to maintain real economic growth of at least 2 percent through 2017, but lower commodity prices will cause government revenues to be a little lower than expected.

Canada may have added 1,800 jobs in October, but that number hides the fact that almost all the gains came from government and that the private sector lost more than 20,000 jobs.

“Details of the report were much worse than the headline number with the private sector showing a loss of 21,000 in October, the fourth decline in six months,” said Matthieu Arseneau, senior economist with the National Bank of Canada. “Over the period, the private sector is actually showing a loss of 12,000 jobs, compared to a surge of 76,000 jobs in the public sector.”

In other words, the economy in terms of productive private sector jobs has been shrinking for six months.

What makes this scene especially disturbing is the record personal indebtedness of Canadians. The Canadian economy has no credit resiliency to resist a major recession. If we look at the following chart taken from the Winter 2011–2012 Bank of Canada Review (What Explains Trends in Household Debt in Canada?),

we note that in 2011, Canadians carried a debt load that in terms of disposable income, was higher than the US, the UK and the Euro area, at about 150%. Recently, the CBC reported (Canadian household debt hits new high) that according to the latest data from Statistics Canada, The ratio of credit market household debt to disposable income hit 163.4 per cent in the second quarter, up from 161.8 per cent in the previous period.

The effect of this high debt load can affect consumers materially in terms of default if they lose their jobs in an economic slowdown, and psychological causing them to curtail spending or to increase debt repayment or savings. Both factors can deepen recessionary tendencies.

We have been reading about and participating in the “bailout” of European economies for years now. To understand what this means and has achieved, we begin with an examination of the term. A few definitions are (our added emphasis):

Google: An act of giving financial assistance to a failing business or economy to save it from collapse.

Wikipedia has a more interesting definition: A bailout is a colloquial pejorative term for giving a loan to a company or country which faces serious financial difficulty or bankruptcy. It may also be used to allow a failing entity to fail gracefully without spreading contagion. The term is maritime in origin being the act of removing water from a sinking vessel using a smaller bucket.

As can be seen from the above, the popular understanding of “bailout” is supported, that of saving or rescuing a country that is at the point of an economic collapse. The idea is that with the bailout, the country avoids the collapse and recovers its economic health. The Wikipedia definition however offers an alternate interpretation, that of allowing a “graceful” failure or collapse that minimizes damage to other parties.

Before we explain why the bailouts of the eurozone economies is destined to fail in the popular sense, we consider past IMF bailouts. There is a long tradition of the IMF’s bailing out collapsing economies due to excessive debt. The solution is two-pronged, fiscal and monetary.

Fiscal solutions involve government fiscal policies and programs that reduce spending and possibly increase revenue through taxation – austerity measures. Monetary solutions require the devaluation of the country’s currency, making exports more competitive and boosting economic growth leading to recovery. The result in past instances has been that affected countries returned to economic health in at most a few short years.

There are however, a couple of requirements that facilitate such a turnaround. One is that the global economy be robust and expanding. This allows the effects of monetary policy to quickly gain traction through increased exports. The other is that the country’s economy be closer to the top of a business cycle than the bottom so that the economic contraction created by austerity measures does not damage the economy to the extent of creating a destructive positive feedback loop. In other words, the economy must have room to contract relative to its normal past recessions.

The problem with the current economic environment for the southern eurozone economies is that none of these conditions are met. First of all, no country has its own currency so currency devaluation is not possible and monetary policy solutions are ineffective. Second, the global economy is contracting and much of Europe is in recession or at the bottom of their business cycles, including the economies of the southern periphery. The result is austerity measures are compounding the problem of these counties and their debt rather than leading to economic growth.

But let’s examine what the bailouts to-date have achieved. The major effects have been to provide loans to countries that have been used to recapitalize their failing commercial banks and to provide money to roll over existing sovereign debt as it comes due. Little of the money has actually descended to the level of the average citizens to help alleviate their suffering. Indeed, the austerity imposed as part of the conditions for the loans has increased their suffering immeasurably.

In short, the bailout measures have done nothing to save or rescue these economies. What they have done is to facilitate the transfer of private debt onto the sovereign, allowing the debt holders – the mammoth Northern European banks, to exit their positions in the failing economies at the cost of the citizens of said economies.

To return to the Wikipedia example, the ships of state of the southern periphery are sinking. The bailouts are doing nothing to save or rescue them. The bailouts are only allowing time for commercial banks and private investors to gracefully escape their risk obligations – for the rats to leave the sinking ships.

Here is Gary’s essay, Five Mainstream Economists Sound a Warning. For more by Gary, visit his website at http://www.garynorth.com/.

Gary reviews the situation of the US deficit:

the on-budget deficit: a mere $1.2 trillion a year.

the real federal deficit, which reflects the unfunded liabilities of the federal government, primarily in Social Security, Medicare, and Medicaid … has a present value of $222 trillion.

It cannot, except by one technique, namely, default.

The Fed now owns one in six dollars of the national debt

The five’s conclusion: The problems are close to being unmanageable now. If we stay on the current path, they will wind up being completely unmanageable, culminating in an unwelcome explosion and crisis.

Gary’s conclusion:

Nothing will change Congress. Nothing will change the executive. There will be no cutback in spending until the numbers force the Great Default. … Americans will not be ready. State and local governments will not be ready. … Will you be ready?

There are a number of different channels — mortgage rates, I mentioned other interest rates, corporate bond rates, but also the prices of various assets, like, for example, the prices of homes. To the extent that home prices begin to rise, consumers will feel wealthier, they’ll feel more — more disposed to spend. If house prices are rising, people may be more willing to buy homes because they think that they’ll, you know, make a better return on that purchase. So house prices is one vehicle.

The part of this phrase we emphasized seems to be the basis for current Fed policy. It also contains a kernel of insight into why the Fed is so dangerous and why its policies no longer work.

Why do they want the consumer to spend? To stimulate the economy. The ‘economy’ is the great abstraction that the Fed thinks in terms of. But they have it all backwards! Their focus is on the ‘economy’ and what they can do to it to shape it into a form they want. The problem is that the economy is an emergent phenomenon, the result of the collective financial interactions of all the individuals, corporations and organizations that participate in it. And the Fed has little direct influence or control over these participants.

The great fear of central planners is that natural systems such as economies and markets, if left to themselves, will self-destruct or at least be subject to cyclical downturns that cause distress to some participants. A frequent argument for their interventions is the allegory of the “Tragedy of the Commons”. The fallacy in this thinking we discussed in Negative Feedback, the Tragedy of the Commons, and Complex Systems. Complex systems do not respond in the long run either well or predictably to centralized planning and control.

The Fed Is Wrong

If we were to use the analogy of the Tragedy of the Commons, the Fed would be the town council urging everyone to buy more cattle to pasture to raise the aggregate income of the community. The consumer would be the farmer who sees progressively less return for the cattle he is already grazing and tries to reduce his herd and his exposure to the debacle in progress.

Since the recession began, we have regularly heard authorities urging policies that would encourage consumer spending. We have concluded in Portrait of the American Consumer, that:

At a ratio of 120% debt/income, the consumer has little room and apparently little inclination to take on more debt. Moreover, with interest rates across the yield curve at historic lows and the fact that consumers are not taking advantage of this suggests that we are at a credit limit.

total household credit market debt is decreasing but this as we see above is entirely due to the decline in mortgage debt. The upturn in non-mortgage debt is troubling. We do not see that the consumer will be in a position to raise GDP significantly any time soon.

We maintain the position that the consumer has reached his credit limit and knows it. This of course renders all Fed stimulus ineffective in the most important segment of the economy. The Fed’s last bullet, the psychological inducement to spend created by the “wealth effect” in the stock market, seems to be giving little traction to the economy at the cost of creating a stock market bubble that must end in at least a violent correction (crash). This is paper wealth and a serious attempt by market participants to crystallize the apparent wealth as real wealth will crash the market.

We received a link to a special report at Comstock Partners: The Deleveraging of the Two Most Outrageous Financial Manias in History. This prompted us to take another look at consumer debt. In Figure 1, we plotted (blue line) total household credit market debt (CMDEBT) – total household mortgage debt (HHMSDODNS) as a percentage of disposable income (TDSP). This represents all non-mortgage debt including credit card debt, student loans and other personal and car loans. It has tripled since 1980. Over the same period, however, the debt servicing cost as a percentage of disposable income has remained roughly constant in the 11-14% range (red line). This is thanks to the fall in interest rates shown in this picture by the Effective Fed Funds Rate (EFFR green line) as a proxy.

Figure 1. Household non-mortgage credit market debt and debt service cost as a percent of disposable income shown with the EFFR. (Click on image to open in a new window)

We suggest that with interest rates near their lower bounds, the consumer cannot take on more debt and maintain a constant level of debt service payment, something that he seems predisposed to maintain at this level.

The figure in the Comstock report, Household Debt Percent Of GDP, shows that the total household credit market debt is decreasing but this as we see above is entirely due to the decline in mortgage debt. The upturn in non-mortgage debt is troubling. We do not see that the consumer will be in a position to raise GDP significantly any time soon.

This time around the world’s central banks have a new set of tools. In past cycles money was mostly gold and silver, which is to say it was real and in limited supply. Credit might have been flexible because of fractional reserve banking, but the money at the base of the financial system couldn’t be created out of thin air. Today, in contrast, it can. Since the US broke the final link between national currencies and gold in 1971, everyone has been running fiat currencies that can be created in infinite quantities and depend for their value on the trust we place in the competence and honesty of our leaders.

Indeed, the primary reason proponents urge a return to a gold standard is to contain the money supply and indirectly, the credit market and the economy. The effect on the economy we will put aside, but we do want to consider the relationship between base money and the total money supply and the credit market.

In this essay, we want to argue a result of any market that individuals trade in. We recognize that such markets are dynamic or complex adaptive systems and as such we lack the tools to effectively determine quantitative results. We use a very simple case to derive our arguement from but we feel that contained within the simplicity is a kernel of truth. Our argument is that in any market, impatience costs money.